James Tobin Got It Right

Over at the Money View at the INET website, Daniel Neilson recently wrote a critique of one my all-time favorite papers, “Commercial Banks as Creators of Money,” a paper that I have previously praised and written about (here and here). The paper is not universally popular; old-style Monetarists, like Leland Yeager and Karl Brunner, seem especially critical of it. But as I pointed out here, Milton Friedman and Anna Schwartz wrote about it very favorably. So when I saw Neilson’s criticism of Tobin at the Money View, which features both Neilson and Perry Mehrling, I paid close attention. I don’t know Neilson, but I do know Perry Mehrling, and he is a very interesting and knowledgeable economist, whose book on Fischer Black is just outstanding. Since it seems to me that Black’s view of money is very much in the spirit of, if not directly influenced by, Tobin’s paper, I was a bit surprised to find Mehrling’s co-blogger writing critically about Tobin’s paper, though obviously Neilson isn’t obligated to agree with Fischer Black, much less James Tobin, just because Perry Mehrling wrote a biography of Black.

At any rate, Neilson makes some good points, so it is worth following his argument to see if he really does prove Tobin wrong.

Neilson starts by acknowledging an important point made by Tobin, while registering a strong reservation:

I agree wholeheartedly with Tobin’s dismissal of the

mystique of “money”—the tradition of distinguishing sharply between those assets which are and those which are not “money,” and accordingly between those institutions which emit “money” and those whose liabilities are not “money,”

but rather than enclosing the difficult word in quotes, I prefer to try to understand it. By all means let us not draw an arbitrary line between money and non-money. But Tobin is wrong to conclude that there is nothing special about money at all.

Neilson continues:

Moneyness should, moreover, be viewed as a property which can be possessed in degrees. No arbitrary line should be drawn, but some things are more like money than others: federal funds are very money-like, T-bills less so, equity shares not so much at all. The degree depends on how deeply the liquidity of each type of claim is supported by the banking system.

Asking whether the fact that their liabilities are monetary means that banks have privileged access to funds, Tobin finds that

[t]his advantage of checking accounts does not give banks absolute immunity from the competition of savings banks; it is a limited advantage that can be, at least in some part for many depositors, overcome by differences in yield.

Tobin imagines banks raising funds by issuing various kinds of securities—checking deposits, savings deposits, bonds, shares—and competing on yield with other issuers to raise funds. But the differences among those liabilities are not to be found only in yields. They possess moneyness to varying degrees, and when the need is for liquidity, no yield is high enough to entice lenders. Yield and liquidity are not commensurate, especially in a crisis.

A fair point, but in some circumstances, the liquidity offered by some assets may be enough to satisfy those seeking liquidity and in other situations even the liquidity offered by a commercial bank may not suffice, as is obviously the case during a bank run. Few people before September 2008 had any doubts about the moneyness of money market mutual fund shares which were guaranteed to be redeemable at par. But having invested in commercial paper issued by firms that had invested heavily in mortgage backed securities, the very money market securities that seemed completely liquid were no longer considered to be absolutely liquid. It is not necessarily the precise definition of the institution issuing a liability that determines its liquidity in a particular set of circumstances.

But here is where Neilson comes to the key point of Tobin’s argument.

Asking whether, in aggregate, an expansion of bank lending necessarily entails an expansion of deposits, he says that

[i]t depends on whether somewhere in the chain of transactions initiated by the borrower’s outlays are found depositors who wish to hold new deposits equal in amount to the new loan.

That is, Tobin says, the deposit that a bank creates for its borrower is soon spent, and so this deposit cannot be said to fund the loan for that bank. Moreover, it can neither be said to fund the loan for the banking system as a whole, because deposits will be held only if someone wishes to hold them.

In other words, what Tobin is saying is that banks can’t just arbitrarily issue money that must inevitably be held by the public forever and ever, independent of economic conditions. There is a certain ambiguity here about what it means to say that banks have the power to force the public to hold money. Could banks physically maintain in circulation a stock of money greater than the pubic wished to hold. Perhaps they could. But that doesn’t seem to me to be the relevant question. The relevant question is whether banks would have an economic incentive to maintain a greater quantity of money in circulation than the amount that the public wanted to hold. And that is what Tobin meant when he said that there must be depositors willing to hold the new deposits created by the banking system.

But Neilson doesn’t see it that way.

On this point Tobin is simply wrong. He neglects to consider who has the initiative in deposit creation and destruction. A bank’s role in the payment system, and the very reason that its deposit liabilities serve as money, is that they guarantee conversion of bank deposits at par, conversion into cash or conversion into deposits elsewhere in the system, at the initiative of the depositor.

A borrower can exit a position in bank deposits in two ways—by selling them to a non-bank, for example by buying real goods, or by selling them to a bank, for example by buying bank bonds. The former does not destroy aggregate bank deposits, it just moves them from one bank’s balance sheet to another’s. The latter does destroy aggregate bank deposits, but only if some bank is willing to sell bonds. Thus deposit destruction can happen only at a bank’s initiative.

The distinction about who has the initiative in deposit creation and destruction doesn’t seem to me to be the relevant one for this analysis. Sure banks commit to convert their liabilities at par — a dollar of currency in exchange for a dollar of deposits, and vice versa. What Neilson loses sight of is that, while banks are making new loans, the public is also repaying old loans, and whether the total quantity of deposits is increasing or decreasing depends on whether banks create new deposits as they make new loans faster than the public is paying back its loans to the banks. And how fast the banks are creating new deposits depends on the economic incentives for creating deposits reflected in the structure of yields on alternative assets and liabilities, and on the costs banks expect to incur in financing their creation of deposits. If banks expect that the public will hold additional deposits, it will be more profitable to create additional deposits than if the banks have to borrow reserves in order to meet an increased deficit in interbank clearings. The quantity of loans being made and the quantity of deposits being created are the result of the interaction of economic decisions being made by banks and the public reflected in the entire spectrum of yields on the full range of assets and liabilities purchased and sold by banks.

Money (bank deposits) may have special features, but the decision-making process that determines the amount of money in existence at any moment of time is not essentially different from the process by which the amount of other financial instruments created by other financial other intermediaries is determined.

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20 Responses to “James Tobin Got It Right”

Tobin”s key error was in making a false distinction between “fountain pen money” and “printing press money”.

“(1) Unlike governments, bankers cannot create means of payment to finance their own purchases of goods or services. (2) Bank created “money” is a liability, which must be matched on the other side of the balance sheet. And banks, as businesses, must earn money from their middleman’s role. (3) Once created, printing press money cannot be extinguished, except by reversal of the budget policies which led to its birth. (4) The community cannot get rid of its currency supply; the economy must adjust until it is willingly absorbed. The “hot potato” analogy truly applies. (5) For bank-created money, however, there is an economic mechanism of extinction as well as creation, contraction as well as expansion.”

1) A government prints 100 paper dollars and uses them to buy a $100 desk. The desk becomes the government’s asset while the paper dollars are its liability. A private banker creates 100 checking account dollars and does the same thing. It’s even more obvious for a private note-issuing banker.

2) Government-created money is the government’s liability, matched by government assets.

3) Government-created money is extinguished when people pay their taxes in that money, when the government sells its assets for its money, and when the government receives repayment of loans it has made.

4) Unwanted money refluxes to its issuer. The government might refuse to accept the reflux, but that’s an effective default. The money would then lose value because it has lost backing, not because its quantity is excessive

5) Bank-created money refluxes to its issuer just like government-created money does, and the consequences of refusing to accept the reflux would be the same.

While I’m on the subject, I can’t emphasize this point enough: Reflux preserves the value of money, NOT because it prevents the quantity of money from becoming excessive, but because it provides channels through which customers can access the assets backing the money.

Ritwik:
I can’t forecast inflation any more than I can forecast the stock market. I’m just saying that IF some entity (central bank, government, etc) issues more money, then that issuance of money will only be inflationary if the issuer’s assets become insufficient to buy back all the money it has issued.

Your question about satiation raises too many issues and sub-issues for me to answer in a blog comment. I’d be glad to take the discussion to email.

Also I just discovered your blog post on fiat money and I’ll look into it. For starters, the real bills doctrine (aka backing theory) is not tautological, but the quantity theory certainly is.

But your example shows why I consider your characterization to be a tautology. If inflation follows, you will just say that the assets backing the expansion in reserves have lost value. If there is no inflation, you will claim that the assets backing the reserves are sufficient.

To say that the assets are sufficient/ insufficient is logically the same as saying that the price level is stable/ accelerating. I don’t see how two ways of framing the same sentence can be seen as connected in a causal manner.

The RBD of the British bankers was a matter of practical advice – if you want to keep your shirt on, ensure that the lending is well collateralized. As a matter of monetary theory, it translates into – if you want to keep the price level stable, keep the price level stable. It does not tackle what exactly makes the lending well collateralized, and independent theory of which should be able to explain the price level to prevent the RBD from becoming a tautology.

I don’t necessarily wish to defend the QTM. Happy to take the discussion to email (ritwikpriya@gmail.com).

Interesting thing about your comment is that from the excerpt it seems that Tobin believes in a monetary hot potato, while David rejects this and accepts the law of reflux following Tobin! So what position characterizes Tobin’s views the best?

The real bills doctrine (I prefer ‘backing theory’, since the RBD has been so mis-stated and misunderstood) says that the value of money is determined by the value of the assets backing it. The theory of finance says that the same rule determines the value of stocks, bonds, etc. Nobody claims that the backing theory of stocks and bonds is a tautology, even though finance prof’s tell me that it’s very hard to test it empirically. It’s at least as hard to test the backing theory of money, but there’s a difference between “hard to test” and “tautology”.

The trouble with Tobin is that he saw that fountain pen money is the liability of its issuer, so that its value could be determined by backing, but he failed to see that printing press money was also the liability of its issuer, and its value was determined on the same principles. The same mistake was made by John Fullarton during the banking school debates, and the same mistake was made by Charles Bosanquet during the Bullionist debates. This mistake has always left the RBD open to attack, and the RBD has been rejected just because its adherents failed to see the mistake.

I find this all very puzzling. When a bank creates a deposit, the bank doesn’t guess that the “public” will be willing to hold more money. It has a specific customer who has already signaled a desire for that money. The customer wants the money so much, he is willing to promise to pay the bank even more money at some point in the future. Under some circumstances the bank decides that the customer’s promise is worthy of faith. The bank is in those cases willing to create that deposit balance for the customer – a liability for the bank – in exchange for the promise of the future delivery of a monetary asset of greater quantity.

I also believe the hot potato conception is deeply flawed. Yes, for a given expected quantity of income to be added to the agent’s monetary stock during some time period, the agent will have some intention – or at least an expectation – about the proportion of the total that will be held at the end of the period, and the portion that will have been spent. But if the agent receives more income during the period, that in no way creates an incentive for the agent to spend more money so as to preserve the expected holding ratio. Having more money, modulo a given quantity of spending, always dominates for a rational economic agent over having less money with the same quantity of spending.

“In other words, what Tobin is saying is that banks can’t just arbitrarily issue money that must inevitably be held by the public forever and ever, independent of economic conditions.” All Tobin has done here is to re-discover the so called “Real Bills Doctrine”, which was discussed by economists in the 1700s and 1800s.

Banjamin Franklin was aware of the above point in the early 1700s. See:

Mike, As I have suggested before, I think that at least one approach to reconciling your position with the more orthodox one about government-issued fiat money is to take explicit account of the value of the government’s monopoly over issuing certain types of money, e.g., banknotes. That monopoly allows the government, if it wishes to do so, to impose an inflation tax. So while I think that the reflux that you are talking about also affects the government, the absence of competition does allow the government greater scope to inflate than competitive banks would have. The value of the monopoly depends on the public’s demand for real cash balances, so the value of the assets backing money depends not just on the non-monetary assets held by the government but on the public’s demand for money as well.

Ritwik, I believe that the solution of the paradox (at least in part) comes back to whether there is competition in the supply of money. Reflux depends on competition.

ruggedegalitarianism, A bank has a specific customer seeking to borrow, but banks have to make a calculation about the profitability of lending. If they lend, creating a deposit but find that all the new loans are being spent and being redeposited in other banks, the bank will have to find some way to finance all the demands being made upon it at the clearinghouse, so it will either have to borrow the funds or it will have to offer depositors more attractive terms to keep deposits with the bank. If the interest rate at which the bank can lend is not sufficient to cover the “costs” of inducing the public to hold deposits or of obtaining sufficient capital to finance its negative balance at the clearinghouse, and all the other costs of servicing loans and deposits, the bank will decide that its lending, at least at the margin, is unprofitable and will make fewer loans.

Ralph Musgrave, Actually, I believe it is the law of reflux rather than the real bills doctrine that is relevant here. I am not sure if Mike and I are exactly on the same page on the distinction between the law of reflux and the real bills doctrine. I wrote a paper about 20 years ago trying to make clear the distinction, “The Real Bills Doctrine in the Light of the Law of Reflux,” History of Political Economy (1992) 24:201-28.

I have a few problems with the view that government monopoly of note issue allows it to impose an inflation tax:
1) Do you mean that a government note backed by assets worth 1 oz of gold will trade for something more than 1 oz.? Seems too weird.
2) As checking accounts, credit cards, and other derivative moneys are issued, any monopoly premium on notes gets competed away.Then the issuers of derivative dollars could sell base dollars short and profit from the very inflation they caused. Also very weird.
3) Where countries are small, weak, and close together, competition between currencies seems to prohibit any monopoly premium .
4) Empirically, a monopoly premium would mean that total bank notes issued by some entity would exceed the value of the assets of that entity. But everywhere I look, I see assets just sufficient to cover the money issued.

“… deposit destruction can happen only at a bank’s initiative.”
It seems to me that Neilson has forgotten something fundamental. If a depositor withdraws his deposits in cash, this destroys deposits at the initiative of the depositor.

If that is the case then what is the substantive difference between Tobin and Laidler. Or indeed between you and Nick Rowe. Surely, Nick also believes that the hot potato only applies to central bank money?

Thanks for reading my post, and for the careful thought you gave it. Just a couple of responses.

You write that “It is not necessarily the precise definition of the institution issuing a liability that determines its liquidity in a particular set of circumstances.” This is a statement with which I agree completely. Your example of money-market mutual fund shares is on point: they may have been issued by commercial banks, but were not backed by deposit insurance, nor by the central bank. They thus seemed like money during good times, and that property vanished quickly in the crisis. I always use the word “bank” to mean an entity that does banking work, which does not always overlap perfectly with the work done by entities that have that word above their front doors.

Further down you write “[t]he relevant question is whether banks would have an economic incentive to maintain a greater quantity of money in circulation than the amount that the public wanted to hold. And that is what Tobin meant when he said that there must be depositors willing to hold the new deposits created by the banking system.” And then “What Neilson loses sight of is that, while banks are making new loans, the public is also repaying old loans, and whether the total quantity of deposits is increasing or decreasing depends on whether banks create new deposits as they make new loans faster than the public is paying back its loans to the banks.”

Here I think we are talking about something different. I had in mind a single transaction. Take as given that it is in line with everyone’s incentives. My question is mechanical: if a bank executes the transaction, lending and creating a deposit, is it possible that the system will choose not to hold those deposits? Tobin’s answer: it is possible, if depositors wish to hold something else. My answer: it is possible *only if* banks are willing to change their liability structure at the initiative of the holders of those liabilities. That is the case when it is a market-maker, and not otherwise. And when a bank is a market-maker in its own liabilities, whether deposits or otherwise, then those liabilities are thereby made more moneylike.

The creation of currency is surely fascinating when understood properly. The same goes with the paper markets derivatives for example. We should also mention that this markets have been manipulated by the same banks that are creating this artificially instruments. It just gets worse the more you know about the system.

“Do you mean that a government note backed by assets worth 1 oz of gold will trade for something more than 1 oz.? Seems too weird.”

I don’t think it’s weird at all. There’s a demand to hold money, if the government restricts the supply of money, its real value can rise above the cost of reproducing it. A Rembrandt is worth more than the cost of the materials embodied in it, because it is highly demanded and can’t be reproduced. In World War I, a few neutral countries on the gold standard restricted their purchases of gold so that the value of their currencies did not fall as much as gold did.

“As checking accounts, credit cards, and other derivative moneys are issued, any monopoly premium on notes gets competed away.Then the issuers of derivative dollars could sell base dollars short and profit from the very inflation they caused. Also very weird.”

All derivative monies trade at par with government currency. For your case to work, derivative monies would have to appreciate relative to dollars, but if they did that they would destroy the network effects that they benefit from by maintaining convertibility at par with the dominant or base money.

“Where countries are small, weak, and close together, competition between currencies seems to prohibit any monopoly premium .”

Agreed. That’s not true of the US dollar and certain other currencies of big powerful nations.

“Empirically, a monopoly premium would mean that total bank notes issued by some entity would exceed the value of the assets of that entity. But everywhere I look, I see assets just sufficient to cover the money issued.”

How could you possibly tell the relationship between the outstanding stock of US dollars and the assets backing those dollars?

Lawrence, Agreed.

Ritwik, I would have thought that that is what he believes, but he insists that he (and Laidler) don’t believe it. And when I said that I didn’t think that that’s what Laidler believes, he produced an email from Laidler saying that Nick was correctly representing his (Laidler’s) views. Go figure.

Tas, Once we get very far beyond bank deposits, it starts to make my head spin.

David:
1) “if the government restricts the supply of money, its real value can rise above the cost of reproducing it.”

Suppose that the optimal size of a firm is to have $10B worth of assets, against 1B shares of stock, so that each share is worth $10. If the firm restricted the number of shares to 0.9B, then it would necessarily have only $9B worth of assets, and the share price is still $10. The restriction only leaves us with a suboptimal number of shares, without raising their value. The same thing is plausible for money: Restricting its quantity (and the assets backing it) only creates a shortage of money, with no effect on its value. (This also gives an alternate explanation of the “sticky prices” view of the world. Quantity theorists see the quantity of money drop by 10% and expect prices to drop 10%. When they don’t, they think prices must be sticky, and they think sticky prices cause a recession. The backing view is that the 10% drop in M is accompanied by a 10% drop in assets, so prices don’t change. But there is a 10% shortage of money, and that’s what causes the recession.)

Also, if a certain kind of money is artificially restricted, another will take its place. Like Wicksteed said about the “Italian Coppers”.

2) “For your case to work, derivative monies would have to appreciate relative to dollars”

I didn’t say that right. Anyone who borrows base dollars and spends them is thereby in a short position in dollars and will gain as the dollar loses value. Similarly, anyone who buys on credit is also short in dollars. If, for example, I buys $1 of goods in exchange for my $1 IOU, then the IOU itself competes with base dollars and reduces their value, and the value of my IOU falls in step. I gain as the dollar falls. Still weird.

3) “How could you possibly tell the relationship between the outstanding stock of US dollars and the assets backing those dollars?”

Good question. It’s about as hard as discerning the value of the assets backing shares of some corporate stock. You have to look for obvious cases, like cases where assets lose all value, and the currency (or stock) loses all value as a result. But of course most central banks get $1 worth of assets for every dollar they issue, so a good first guess is that the bank’s assets are equal to the amount of money it has issued.

About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.